Oil Stocks Undervalued 2

The grinding 6-week-old bottoming process following the stock-market correction
is doing its job, shaking out all the weak hands. These traders who haven't
learned to suppress their own fear are selling low, disproportionately hammering
popular sectors like commodities stocks. Excessive and unsustainable fear drives
incredible bargains, including in oil stocks. They are super-oversold and very
undervalued.

Of course oil stocks produce oil, the lifeblood of our global economy. Oil
is the world's only meaningful transportation fuel, without it nothing moves.
If goods can't be shipped, stores have nothing to sell and we all starve. As
the foundation of this entire planet's complex logistics network, oil is worth any price.
Adding to its value, once it is consumed it is gone forever. And large new
deposits are ever harder to find.

So the producers of the world's most-important commodity enjoy a unique position.
No matter how much oil they can discover and pump, eager buyers await. Unlike
most businesses that never know whether their products will be in demand or
not, oil is always in demand. Every barrel produced can be easily
and quickly sold. And with half the world still industrializing, global oil
demand is only going to grow.

As a small businessman, I marvel at this. Imagine effectively-infinite demand
for your product, no matter how much you manage to ramp up your production!
Oil producers are in the catbird seat like few other companies can imagine.
And no matter how scary the stock markets get, goods and people still have
to move. As we saw during 2008's epic once-in-a-century stock
panic, oil demand is largely immune from even extreme stock fear.

Every company's stock price ultimately gravitates to levels that reflect its
profitability, and oil producers' profits are directly driven by oil prices.
So naturally higher oil prices lead to higher oil-stock prices. But stock-market
fear causes traders to forget this critical fundamental link. They get so busy
trying to rationalize their inherently-irrational fears that they forget oil
prices are the key to oil-stock prices.

This is readily evident in the flagship oil-stock index, established 27 years
ago but now unwieldly called the NYSE Arca Oil Index. Thankfully it is more
commonly known by its ticker symbol, XOI. This index contains 13 major oil
stocks with a mammoth collective market capitalization of $1450b as of the
end of August. To put this into perspective, the 100 elite tech stocks of the
NASDAQ 100 were only worth $2511b together. The XOI only has 13% as many components,
but 58% of the market value!

Since oil prices directly drive oil-producer profits, the XOI/Oil Ratio is
a great valuation proxy for this sector. As an American, I use benchmark US
West Texas Intermediate crude oil in the denominator of this ratio. But this
year we've seen problems with WTI, a local supply glut has led this metric
to decouple from global oil prices. Earlier this week, WTI was still trading
at a massive $25 discount to the global Brent oil price! Using WTI radically understates the
case for rampant oil-stock undervaluation today.

This first chart looks at the XOR since 2008's stock panic, superimposed over
the raw XOI itself. Though oil prices drive oil-stock profits, and profit levels
ultimately determine stock prices, there has been a big disconnect between
oil stocks and the crucial product they produce. Not only has oil-stock undervaluation
been chronic since the panic, it is exceptionally so today following the recent
sharp general-stock correction that has so frightened traders.

The first thing to realize is how anomalous this entire chart is. The last normal years
for the stock markets prior to 2008's tremendously-disruptive stock panic were
2006 and 2007. Over this normality baseline, the XOI/Oil Ratio averaged 17.9x.
In other words, the XOI oil-stock index generally traded at 17.9x the price
of crude oil. Since they weren't so scared and jumpy back then, traders supported
oil stocks at far-more-reasonable levels based on their core oil-driven profit
fundamentals.

Back in December 2007, oil averaged just under $92 while the XOI averaged
1501 on close. Fast forward to July 2011, before the lion's share of
the recent correction that terrified traders hit. Though the average oil price
was 6.0% higher near $97, the XOI averaged 1314 which was 12.4% lower.
And then in August when traders dumped oil stocks like oil was going obsolete,
this divergence ballooned dramatically. The average oil price was just 6.0%
lower than December 2007's, but the average XOI close was a whopping 24.2%
lower!

This valuation of oil stocks relative to oil made no sense at all. Since the
recent stock correction, oil has meandered between $80 and $90, averaging $86
in the 6 weeks since the flagship S&P 500 stock index (SPX) bottomed. Yet
despite oil staying so strong even in the midst of stock fear slamming into
its effective
ceiling, oil stocks were disproportionately crushed. The XOI was trading
around levels first seen back in mid-2006 when oil was in the mid-$60s! What
on earth are traders thinking?

The chart above shows oil-stock undervaluations have been chronic since the
stock panic. We have yet to get anywhere close to the normal baseline XOR levels
seen in the pre-panic years. Capital invested in the major oil stocks comprising
the XOI has unfortunately remained far below its pre-panic levels. Yet even
within this stunted period, the XOR has seen highs and lows. The tide started
to turn in mid-2010.

When the blue XOR line is rallying, oil stocks are outperforming oil. When
it is falling, oil is outperforming the oil stocks. You probably remember the
summer of 2010, when the media was freaking out about BP's infamous Deepwater
Horizon oil spill in the Gulf of Mexico. While certainly a tragic event, traders
lost sight of the inarguable fact that the world still needed vast quantities
of oil despite occasional spills. The oil stocks, even those with no deepwater
exposure, were dumped as if they were radioactive.

But just like today, this was irrational emotional selling. And that
was very obvious at the time to serious students of the markets not deceived
by the silly fear. In fact in July 2010 I wrote my other
essay in this series, arguing that oil stocks were radically undervalued
and a screaming buy. I caught a lot of flak from scared traders, but we bought
oil stocks aggressively. Buying fear is the surest way to earn big profits
in the stock markets. Just 7 months later, our subscribers realized profits
averaging +90%!

While the XOR line above isn't quite as low today as it was in the summer
of 2010, it's been pretty-darned close and right near this ratio's major support
line. Trading at just 12.5x the price of oil is about as out of favor as oil
stocks get as measured by this ratio, and this metric was just hit in recent
weeks. Odds are oil stocks will soon catch a major bid at these levels,
and start regaining some lost ground relative to oil.

Ultimately oil stocks are certain to return to their pre-panic levels in the
years ahead, as the stock-panic trauma and its aftershocks gradually fade from
memory. But we don't need to solely bet on such a radical mean reversion. The
last time oil stocks started gaining some favor was earlier this year when
the XOR surged over 15. At the $86 average oil price in the 6 weeks since the
SPX bottomed, a 15 XOR implies an XOI of 1294. This is 19% higher than where
the XOI was trading this week before its latest plunge!

Now several factors make these potential gains incredibly conservative. First,
oil prices are highly correlated with the US stock markets. Falling stock markets
lead traders to assume the global economic outlook is worse than reality, so
oil is sold aggressively. And as the stock markets recover out of their selloffs,
oil prices rally in sympathy. Considering the extreme stock fear we've seen,
oil has been remarkably strong. If it can still trade between $80 and $90 when
the thundering herd thinks the world is ending, where will it surge to when
traders calm down and get rational again?

Second, this XOR is based on an oil price that is increasingly viewed as a
fiction by the world's oil traders. Despite the glut of oil in Cushing,
Oklahoma where US benchmark oil prices are set, refiners all over the world
(even in most of the US) are buying oil near the much-higher Brent benchmark
price. Earlier this week Brent was running around $110 compared to $85 for
WTI. Some American oil producers are even bypassing Cushing so they can sell
at prices closer to Brent. If this XOR was based on global oil prices, oil
stocks would look far-more undervalued than this distorted WTI read.

Third, the XOI is made up of giant oil companies with mammoth market capitalizations.
They are like supertankers, so large and inertia-laden that their stock prices
are slow to change. As a speculator, I much prefer to trade smaller fast-growing
oil producers. While they fall farther when traders are scared, they really
leverage the upside in oil prices and the general stock markets when fear inevitably
passes and fades. As always, these high-potential smaller oil stocks will really
multiply the majors' XOI gains.

While the focus of this essay is the unsustainable undervaluation of oil stocks
relative to oil, the XOI technicals themselves are also worth considering.
By the end of April when the general stock markets reached their latest interim
high, the XOI had enjoyed a 59.5% upleg over 10 months. This was very similar
to its last upleg ending in April 2010. And since that recent peak, this index
has fallen 25.1% in just over 3 months in a sharp correction. This was very
similar to its last correction in mid-2010.

So technically, despite all the crazy fear out there, the benchmark oil-stock
index hasn't done anything out of the ordinary. Oil stocks rallied dramatically
with general stocks, and then corrected hard with them. But they didn't enjoy
a particularly-outsized upleg or correction, which increases the odds the bull
market in oil stocks is alive and well. It's amazing a garden-variety correction
has sparked so much fear.

This last chart looks at another oil-stock valuation proxy, the ratio of the
XOI to the general stock markets as measured by the S&P 500. This XSR reveals
when oil stocks are outperforming or underperforming the rest of the US stock
markets. Like everything else in the markets, this sector's relative performance
flows and ebbs. Periods of relative oil-stock strength are followed by weakness,
and vice versa.

Though the XOI itself hit its latest interim high in late April the same day
the SPX did, relative to the stock markets the oil stocks actually peaked a
few weeks earlier. This oil-stock correction in relative terms is more mature
than the general-stock correction. On top of that, oil stocks are back down
to mid-2009 levels compared to general stocks. And amazingly they aren't too
far above this ratio's 2008 stock-panic lows!

Given their unbelievably-low price-to-earnings ratios and deeply-oversold
levels, oil stocks are likely to start rallying as soon as the general stock
markets do. And after spending most of this year seriously underperforming
the SPX, they are due to outperform again in their next upleg. While
oil-stock prices relative to oil are far-more important than their levels relative
to the SPX, this alternative perspective is still interesting.

There is no doubt that buying oil stocks when the stock markets are weak and
everyone is scared is tough psychologically. Contrarian trading always is!
But extreme fear leads to the best bargains ever seen in the stock markets.
The optimum time to buy low is when everyone else is selling, so blinded
by their own fear that they can't imagine anything but the current selling
extrapolated out into infinity. But are oil stocks going to remain deeply out
of favor and oversold for the coming 6 months? Almost certainly not.

Today oil stocks are abnormally cheap simply because everyone is scared. But
how long can traders stay scared? Stock-market history is crystal-clear in
showing that extreme fearnever persists
for long, it quickly burns itself out. Contrarian traders strong enough to
suppress their own dangerous emotions can load up on cheap oil stocks today,
when no one wants them. Then all we have to do is allow some time to pass so
rationality can inevitably return to the markets, and then sell high for big
realized profits.

But which oil stocks to buy? My business partner Scott Wright and I were pondering
this very question 4 months ago as we waited for a general-stock-market correction.
So we started a big deep-research project investigating the entire universe
of oil stocks trading in the US and Canada. We focused on mid-cap oil stocks
with market capitalizations ranging from $2b to $10b. This is the sweet spot
of highly-leveraged companies with growing oil production that really amplify
moves in oil and the far-larger XOI stocks.

We just finished many hundreds of hours of research narrowing down these oil
stocks to our dozen favorites fundamentally. They run the gamut from
companies focusing on North Dakota's hot new Bakken oilfield, to incredible
oil-sands projects in Canada, to an offshore producer. Scott wrote a fascinating
and enlightening 36-page report that
profiles each of these elite mid-cap oil stocks in depth. Hot off the presses
this week, it is available for just $95 ($75 for Zeal subscribers). Buy
yours today!

We also publish acclaimed weekly and monthly subscription
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The bottom line is oil stocks are very undervalued relative to the oil prices
that drive their profits. While oil has remained high and resilient despite
all the stock fear, traders are scared. They are foolishly ignoring strong
oil prices to dump its producers with reckless abandon. This has driven oil
stocks down to silly levels that can't and won't last once this fear inevitably
passes over. Contrarians can capitalize on this.

Oil remains the lifeblood of the world economy, and demand is going to grow
relentlessly in the coming years as Asia continues to industrialize. The companies
that produce this unique and scarce commodity will easily sell every barrel
they can pump, likely at high and rising prices for many years to come. Big
profits will attract big capital, driving big gains in oil stocks as they rally
to reflect prevailing oil prices.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
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